Analysis Presentation For External Users

ACCOUNTING AS A TOOL FOR BUSINESS DECISION MAKING
A. R. Suriya & Co.

Chartered Accountants
requires
Quality Decision
Quality Data
INFORMATION DEPENDABILITY
For analysis we need data , so we to decide
A. R. Suriya & Co.
1 What data is required? 2 Whether the decision maker is:
inside user or
outside user?
USERS INFORMATION
A. R. Suriya & Co.
External Users Shareholders Customers Bankers Tax authorities
Internal Users Directors Operating Managers like marketing inventory 4 Internal Auditors
DECISION MAKING FOR EXTERNAL USERS

The external users have to depend on financial statements and annual report to judge operating efficiency, financial condition and future prospects.
A. R. Suriya & Co.
DECISION MAKING FOR EXTERNAL USERS (2)

What are the usual steps for Decision Making ?
A. R. Suriya & Co.
A. R. Suriya & Co.


Before moving to Step A to B, we need another step i.e.
A. R. Suriya & Co.
Before reaching to conclusion based on analysis we need to consider
HOW CAN ONE IMPROVE READING ABILITY AND UNDERSTANDING OF FINANCIAL INFORMATION ? Understanding of the following helps the users of the financial statements to improve their reading ability and understanding of the financial information: Concepts and assumptions for preparation of financial statements like Going Concern , Accrual etc Understanding of Generally Accepted Accounting Standards like IFRS and IAS Statuary requirements for preparation Terminologies used in Financial Statements Annual Report
A. R. Suriya & Co.
ANALYSIS OF FINANCIAL STATEMENTS

Techniques to analyze
Horizontal Vertical Analysis Common-size Financial Statements Ratio Analysis
A. R. Suriya & Co.
Broad Categories of Financial Ratios

Liquidity Assets Efficiency Profitability Market ratios Capital Structure
Analysis of Cash flow Statements
NON-FINANCIAL FACTORS AFFECTING ANALYSIS WHICH ARE NOT PART OF FINANCIAL STATEMENTS
Within Annual Report Auditors Report Directors Report

A. R. Suriya & Co.
Outside Annual Report Government policy, Currency devaluation, Change in products fashion etc.
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RELEVANT RATIOS FOR VARIOUS EXTERNAL USERS OF FINANCIAL STATEMENTS

Creditors
Liquidity Profitability Cash flow analysis
Employees
Profitability growth
A. R. Suriya & Co.
Shareholders
Dividend yield, Dividend payout , EPS Liquidity Cash Flow Analysis
Banker
Debt Equity Interest Coverage Liquidity Profitability
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DECISION MAKING FOR INTERNAL USERS

Relevant ratios for various internal users
Marketing & Sales Manager
A. R. Suriya & Co.
No of days in Account Receivable and Receivable turnover Sales v/s Profit Sales v/s Expenses
Inventory Manager
No of days in Inventory Inventory turnover
Production Manager
Input v/s output ratio cost of sales v/s sales
DECISION MAKING FOR INTERNAL USERS (2)

Are these ratios and analysis based on financial statements enough for internal users?
A. R. Suriya & Co.
DECISION MAKING FOR INTERNAL USERS (2)
A. R. Suriya & Co.
THE ANSWER IS
NO
Analysis of Financial Statements Cash Flow- LATEST VIEWS by External and Internal Users OF CFO IN IFAC has published an article THE ROLE 2010 .This contains interviews of for Business decision the leading CFOs of Making is of international companies. One of interviews
CFO of SEIMENS Mr observation is as follows: Heinz-Joachim whose
ACCOUNTING
IS GOING TO BE LESS RELEVENT, BUT TO KEEP A COMPANY AFLOAT IN DIFFICULT TIMES , TREASURY AND CASH ARE THE IMPORTANT THINGS , NOT BOOK PROFIT.
ANALYSIS OF FINANCIAL STAEMENTS

The word ANALYSIS is a noun and its verb is ANALYSE which means:
to examine in detail in order to discover meanings

Analysis of financial statements is the process of: arranging, manipulating and comparing the results in order that users may make their decisions...
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Analysis of financial statements help provide answers to questions concerning specific issues and insights into the operations of a business enterprise.
Analysis of financial statements can help in learning about a companys strength, weakness, emerging problems, operating efficiency, profitability etc.
Business managers may require to do some analysis of financial data to take help for efficient decisions making.
These analysis may include : Cash flow statement review Liquidity review
Efficiency of receivable and inventory management

Profitability and Capital structure review.
INTERPRETATION PROCESS
Identification of the recipient of the analysis; An understanding of the nature of the business, industry and organization; Identification of sources of data for analysis; Numerical analysis of the data available; Interpretation of the results of the analysis; Writing the report detailing the analysis of the results and recommendations.
MATERIAL NEEDED FOR ANALYSIS

Profit and loss account data for a number of years; Industry-wide ratios and benchmarks; Balance sheet data for a number of years; Budget data, and variance analysis; Data regarding a competitor, potential subsidiary, or customer applying for credit
Benchmark for Comparison

To help me interpret our financial statements, I use several standards of comparison.
Intracompany Intercompany
Industry
Guidelines
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TECHNIQUES TO ANALYSE
1. Comparative financial statements: a. Horizontal analysis (Trend % are a form of horizontal analysis) b. Vertical analysis (reveals the relationship of each statement item to a specified base) 2. Common-size financial statements (reports only in percentages.)
3. Ratio analysis
Example of Vertical Analysis of P/L

Sales Rs Cost of Goods Sold Gross Profit Administration Exp Marketing Expenses Financial Charges 1000 650 350 100 150 50 300 50 100% 65% 35% 10% 15% 5% 30% 5%
Net Profit
Horizontal Analysis
Now, lets look at some ways to use horizontal analysis.
Time
The term horizontal analysis arises from left-to-right (or right-to-left) movement of our eyes as we review comparative financial statements across time. 28
Horizontal Analysis The study of percentage changes in comparative statements is called horizontal analysis. It is more useful to know that sales have increased by 20 percent than to know that the increase in sales is $20,000. It compares the financial data of a single company over several years.
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Example Horizontal Analysis of Balance Sheet

An extract of balance sheet : Year 98 Fixed Assets 1000 Current Assets Stocks 350 Receivable 200 Cash at Bank 250 800 Total Assets 1800 Year 97 800 700 300 200 1200 2000 % Inc/Dec + 25% - 50% - 33% - 25% -33% - 10%
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CLOVER CORPORATION Comparative Balance Sheets 31-Dec 2004 Assets Current assets: Cash and equivalents Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets 2003 Dollar Change Percent Change
12,000 60,000 80,000 3,000 $ 155,000 40,000 120,000 $ 160,000 $ 315,000
23,500 40,000 100,000 1,200 $ 164,700 40,000 85,000 $ 125,000 $ 289,700

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Comparative Statements
Calculate Change in amount
Rupee Change
Analysis Period Amount
Base Period Amount
Since we are measuring the amount of the change between 2003 and 2004, the Rupee amounts for 2003 become the base period amounts.
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Comparative Statements
Calculate Change as a Percent
Percent Change = Rupee Change Base Period Amount
100%
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CLOVER CORPORATION Comparative Balance Sheets 31-Dec 2004 2003 Dollar Change Percent Change*
Assets Current assets: Cash and equivalents $ 12,000 $ 23,500 $ (11,500) Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 Rs12,000 Rs23,500 = Total current assets $ 155,000 $ 164,700 Rs(11,500) Property and equipment: (Rs11,500 Rs23,500) 100% = Land 40,000 40,000 Buildings and equipment, net 120,000 85,000 Total property and equipment $ 160,000 $ 125,000 Total assets $ 315,000 $ 289,700 * Percent rounded to first decimal point.
(48.9)
48.9%
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CLOVER CORPORATION Comparative Balance Sheets 31-Dec 2004 Assets Current assets: Cash and equivalents $ 12,000 Accounts receivable, net 60,000 Inventory 80,000 Prepaid expenses 3,000 Total current assets $ 155,000 Property and equipment: Land 40,000 Buildings and equipment, net 120,000 Total property and equipment $ 160,000 Total assets $ 315,000 * Percent rounded to first decimal point. 2003 Dollar Change Percent Change*
$ 23,500 $ (11,500) 40,000 20,000 100,000 (20,000) 1,200 1,800 $ 164,700 $ (9,700) 40,000 85,000 35,000 $ 125,000 $ 35,000 $ 289,700 $ 25,300
(48.9) 50.0 (20.0) 150.0 (5.9) 0.0 41.2 28.0 8.7

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TREND PERCENTAGES
Trend % are a form of horizontal analysis. It is necessary to look at the trends, generally 3 to 5 years to ascertain how the firms performance is changing over time and to diagnose trends that indicate the magnitude ,timing or risk of the firms future out look. And its comparison with industry in which it operates. Trend percentages are computed by selecting a base year, with each amount during that year set equal to 100 percent. The amount of each year expressed as a percent of the base amount.
Common size statement

The percentages presented as a separate statement that reports only percentages (no rupee amounts). Such a statement, called a commonsize statement, is a type of vertical analysis. EXAMPLE Percent of Total Assets 19X7 19X6
Current assets : Cash .. 3.7% 5.0% Accounts receivable, net .. 14.5 13.2 Inventories 14.3 17.2 Prepaid expenses. .8 1.2 Total current assets ... 33.3% 36.6% Investment advisory services report common-size statements for various industries, and analyst use them to compare a company with its competitors and with the industry average.
Case Study
Prepare Vertical, Horizontal analysis and common size statement for Profit and Loss account of any company
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Using key relations among financial statement items
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Why ratios ?
Figure appearing in Financial Statements normally does not convey any meaning unless its relation is seen with some other figure. Example: Distribution cost may look too high or low but when it is compared with sales it will suggest some purposeful meanings and then this percentage is compared with industry trend.
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Ratio Analysis
A ratio can be computed from any pair of numbers. Ratios are generally not significant of themselves but assume significance when they are compared with : 1. Previous ratios of the same company 2. Some predetermined standard or budget 3. Ratios of other enterprises in the same industry or 4. Ratios of the whole industry within which the company operates
Ratio Analysis ..II

Ratios are not ends in themselves but help provide answers to questions concerning specific issues and insights into the operations of a business enterprise. Ratios be used with caution and should not be the sole basis for decision-making. They should be treated as additional evidence (not conclusive evidence) leading to a decision or solution.
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Ratio Analysis ..III

RATIO provide questions rather than the answers while they are tools which can help managers to make better financial decisions, they should form part of an overall business judgment based on many additional factors.
The need to look beyond ratios
An inexperienced analyst may assume that ratios are sufficient in themselves as a basis for judgments about the future. Nothing could be further from the truth. Conclusions based on ratio analysis must be regarded as tentative in nature.

Ratios should not be viewed as an end, but rather they should be viewed as a starting point, as indicators of what to pursue in greater depth. They raise many questions, but they rarely answer any questions by themselves. In addition to ratios, other sources of data should be analyzed in order to make judgments about the future of an organization.
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The analyst should look, for example, at industry trends, technological changes, changes in consumer tastes, changes in broad economic factors, and changes within the firm itself. A recent change in a key management position, for example, might provide a basis for optimism about the future, even though the past performance of the firm (as shown by its ratios) may have been mediocre.

Market size and growth, possibility of substitution of other products, and industry prospects; Competitors shares of the market, competitors manning levels, wage rates and productivity the extent of spare capacity in the industry, economic forecasts for the industry as a whole and relevant financial analysis and press reports;
Limitation of Ratio Analysis

1. Ratios reflect past conditions (not future) 2. Ratios reflect book values, not current cost or realizable value. 3. The computation of ratios is not completely standardized. 4. The application of accounting principles and policies varies among companies. 5. Inter company comparisons are difficult when companies are diversified or have different risk characteristics.
Ratios
1. Please refer page 71 to 74 for the master list of ratios 2 And page 128 and 129 for the live example of FFCL ratios and page 20 of Siemens
Ratios
Categories
Liquidity
Assets Efficiency
Profitability Market ratios
Capital Structure
Liquidity Ratios
It reflect short term financial strength or solvency Liquidity implies an ability to convert assets its cash or to obtain cash.
Liquidity Ratios
Liquidity and certain areas of operating activity are dependent upon the working capital position ,and their evaluation through ratio is useful in knowing certain trends and relationships involving various aspects of the operating cycle of a business
Liquidity Ratios
Working capital is the excess of current assets over current liabilities the amount of and changes in working capital from period to period are significant measures of a companys ability to pay its debts as they mature.
Current Ratio
Current Current Assets = Ratio Current Liabilities Current Rs65,000 = = 1.55 : 1 Ratio Rs42,000
This ratio measures the short-term debt-paying ability of the company.

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Liquidity Ratios .. II
CURRENT RATIO or WORKING CAPITAL RATIO
It express the relative relationships between current assets and current liabilities. FORMULA: Current ratio = Current assets Current liabilities Current Liability is paid from current assets ,not from selling fixed assets. A very low current ratio is an indication of cash flow problems. An excessively high current ratio could suggest that the company is not managing its current assets like Debtors and Inventory properly. A rule of thumb suggests that 2:1 ratio is satisfactory, but minimum it should be 1:1
Acid-Test Ratio
Quick Assets Acid-Test = Current Liabilities Ratio
Quick assets are Cash, Short-Term Investments, and Current Receivables.
Acid-Test = Rs50,000 = 1.19 : 1 Rs42,000 Ratio

This ratio is like the current ratio but excludes current assets such as inventories and prepaid expenses that may be difficult to quickly convert into cash.
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Liquidity Ratios .. III

ACID TEST RATIO or QUICK RATIO Formula: Acid test ratio = Quick Assets Current Liabilities It is a quick measure of the debt paying ability Quick assets = Cash, Bank balances, Marketable Securities and Accounts Receivables Inventories and prepaid expenses are not considered quick assets because they may not be easily convertible into cash .But if we look at our culture ,debtors are less liquid then stocks. A rule of thumb for the quick ratio is suggested as 1:1
Liquidity Ratios .. IV
CASH RATIO OR SUPER QUICK RATIO It is a more severe test of liquidity than acid test ratio Formula: Cash Ratio = Cash + marketable Securities
Current Liabilities
Liquidity Ratios .. V
WORKING CAPITAL TURNOVER Working capital has special relationship to sales, especially through accounts receivable, inventory, and cash. The ratio of sales to working capital can be used as a measure of the effectiveness of a companys use of working capital to generate sales. Working capital turnover = Net sales Average working Capital
Assets Management Ratios Activity / Turnover / Efficiency/Performance Ratios
It is concerned with measuring the efficiency in current assets management It is used to evaluate a companys operating cycle
Efficiency Ratios
Days Sales Uncollected Accounts Receivable Turnover Inventory Turnover Total Asset Turnover
Days Sales in Inventory
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INVENTORY RATIOS It indicates the number of times inventory is replaced during the year or how quickly the goods are sold It is a test of efficient inventory management. The inventory turnover ratio establishes the relationship between the volume of goods sold and inventory. The inventory turnover for business in different industries and within industries can vary widely. A grocery store may have an average turnover of 20, for all items. A furniture store would normally have a much smaller turnover. Formula: Inventory turnover = Cost of goods sold Average inventory

BENIFITS OF HIGH INVENTORY TURNOVER 1. Operating effectively as far as inventory is concerned (purchasing, receiving, storing, selling) 2. Investment in inventory is reduced 3. The operating cycle (converting inventory to cash )is shortened, 4. Less opportunity for the inventory to become obsolete 5. Saving in storage cost and financial charges DISADVANTAGES an excessive high inventory turnover may suggest that the company is not keeping sufficient inventory to meet sales requirements resulting in stock outs and unhappy customers.
1. 2. 3. 4.
LOW INVENTORY TURNOVER INDICATES : Slow Sales High carrying cost for Inventory Weak cash flow prospects Exposure to future financing problems

NO OF DAY IN INVENTORY Formula = No of days in a year Inventory turnover
This ratio may be useful to assess: (i) future expiry of inventories and (ii) stock out position.
How many no of days inventory is to be kept depends on lead time to order & management policy for inventory investment.
INPUT OUT PUT RATIO Technique to evaluate yield In a manufacturing concern standard yield is compared with actual Input-Output ratio Example : sugar and pharmaceutical industry.

ACCOUNTS RECEIVABLE RATIOS The accounts receivable turnover ratio expresses the relationship between credit sales and accounts receivable. Turnover refers to how often the average receivables were collected during the period. Formula: Accounts Receivable turnover = Net credit sales Average accounts receivable

HIGH ACCOUNTS RECEIVABLE TURNOVER RATIO reflects that the receivable are being :
Effectively managed Fewer resources are invested in receivables Better credit policies Better collection practices Last but not least, it reflects that demand of the companys product and services is good. Naturally if the products or services are not up to mark then it will effect all viz sales , collection , credit policy etc.

NO OF DAYS SALES IN RECEIVABLES Formula: Collection period = Days in a year Accounts Receivable Turnover Number of days sales is compared with Companys credit term and industrys normal credit terms. It also help in knowing age of receivables (which helps in credit control and avoid bad debts )

ASSETS TURNOVER It indicates how efficiently assets are used to achieve sales. The higher ratio indicates that the assets are more effectively used to generate sales . Its comparison with other company in the same industry provides meaningful data is to how efficiently the management using the assets to generate sales. Formula : Assets Turnover = Sales Average total assets

Formula Payables to Purchases
A/c Payable Purchases Average days purchase = Purchases Days Days purchases in payables = A/Cs Payable average days purchases
The days payable ratio is useful when compared to the credit terms given by suppliers. If the average days payables is increasing, it could mean that trade credit is being used increasingly as a source of funds.

OPERATING CYCLE OF A BUSINESS Formula = No of days Sales in receivable + No of days in Companys inventory - No of days purchases in creditors Operating cycle indicates no of days the Companys cash is tied up in inventory & receivables A Company with a short operating cycle typically requires only a small amount of working capital It helps in assessing working capital requirements

Ratio Sales/number of calls Travel expense/days Selling expenses/sales Sales/sales orders Number of calls/days To Analyze Response per call Cost awareness Response per selling effort Sales efficiency Sales effort
These ratios are useful in developing trend information and an overall picture of the companys sales efforts We can see the relation of sales with various expenses and other marketing activities, as there may be many other ratios depending upon the need of the company.
Profitability
Profit Margin Basic Earnings per Share Book Value per Common Share Return on Common Shareholders Equity
Gross Margin
Return on Total Assets
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Profitability
Profitability is the ability of the Company to generate earnings Concerned Person
Shareholder
Dividend Rise in Stock Market & avail Capital Gain

Creditors/Bankers
Profits are source of funds for debt Coverage & repayment on due dates Absolute profit figures are meaningful when it is measured with sales, capital Employed, Productive assets Profitability ratios have been developed to measure operational performance.
Profit Margin on Sales

Formula-1 = Net income Net sales This ratio reflect the ability of the Company to control costs and expenses in relation to sales Formula- 2 = Gross Profit Net sales GP ratio is important for Tax Authorities and also for management of the company to know the efficiency of sales and cost pricing
Return on Total Assets

Return on = Net Income Total Assets Average Total Assets
This ratio is indicates how companys resources were used in generating profits
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Return on Shareholders Equity

Return on Common Shareholders = Equity
Net Income - Preferred Dividends Average Common Shareholders Equity
This measure indicates how well the company employed the owners investments to earn income.
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Return on Stockholders Equity

Return on stockholders equity indicates managements success or failure at maximizing the return to stockholders based on their investment in the company. This ratio emphasizes the income yield in relationship to the amount invested.
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Basic Earnings per Share

Basic Earnings Net Income - Preferred Dividends = per Weighted-Average Common Share Shares Outstanding
EPS is disclosed below the P/L A/c
This measure indicates how much income was earned for each share of common shares outstanding.
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Return on Investments
Many analysts Consider return on investment (ROI) one of the most important ratios for evaluating profitability because it relates earnings to investment. Return on investment can be computed on the following bases:
1. Total assets 2. Shareholders equity 3. Comprehensive basis
Return on Investment
Formula :
ROI =
=
Capital Turnover x Profit Margin

Sales x Capital employed Net income Sales
It is a comprehensive measure of financial performance
Activity / Turnover / Efficiency Ratios ..V

Condensed Income Statement Sales Less: Costs and expenses Net income Balance Sheet Working capital Plant and equipment Total assets (Capital employed) Capital Turnover (Sales / Capital employed) Profit Margin (Net Income / Sales) ROI (Capital Turnover x Profit Margin) $100,000 $300,000 $400,000
250% 20% 50%
$1,000,000 $800,000 $200,000
Capital Employed Turnover

Capital turnover is the ratio of sales to capital employed in generating the sales Capital turnover is a measure of the use of assets in relation to sales Capital employed can be either
Working Capital Total assets
Investment Turnover Ratio / Assets Turnover Ratio

Formula Assets This ratio also measures the effectiveness with which management used available resources in relation to sales = Net Sales Average Total
Advantages of ROI Analyses

1. 2. 3. 4. 5. 6. Focuses managements attention upon earning the best return on total assets. Serves as a measure of managements efficiency and effectiveness. Integrates financial planning, budgeting, sales objectives, cost control, and profit-making activities. Provides a basis for comparing companies. Provides a motivational basis for management. Identifies weaknesses in the utilization of assets.
MARKET RATIOS Price Earning Ratios (P/E)

P/E is often referred to as the Market Capitalization
ratio.
P/E is used to measure the relationship between the market value of shares and earnings. P/E reflects to some extent the growth potential of a company and the markets evaluation of the firms earning. P/E ratio express what the market is willing to pay for every single rupee P/E increasing ratio is generally considered a favorable growth indicator Formula : MV of Ordinary Shares EPS For buying shares the PE ratio differs from company to company and market situation.
Dividend per Share

It reflects the dividend distributed per share
Formula
Dividend No Ordinary Shares
Dividend Yield
It is a measure to calculate total return Formula = Dividend per share M/V of Ordinary Shares
Dividend Payout Ratio

It indicates the income available to Ordinary Shareholders that has been distributed as dividend. It reflects the dividend policy and to some extent managements perceptions regarding the uncertainties associated with future earnings. Formula-1 = Cash Dividend Net Income Preference Shares Dividend Formula 2 = Dividend on Ordinary Shares EPS
Other Analyses
1. 2. Additional ratios are available to evaluate specific areas of profitability related factors. The ratio of selling, general, and administrative expense to sales provides some information concerning the effectiveness of cost control efforts undertaken by the company as well as managements efficiency of managing operating expenses in relationship to changing sales volumes. Trend analysis is particularly useful in identifying areas of strength or weakness; any significant fluctuations in the trend should be investigated The ratio of advertising to sales is especially useful in evaluating consumer-oriented enterprises. Inter-company and industry comparisons are especially relevant in such situations.
3.
4.
Other Analyses
5. Operating profit per unit of capacity or service, such as per room for hotels or per bed for hospitals, indicates the profitability of available physical resources and compares operations of different sizes.
6.
Productivity ratios attempt to measure both output and input in physical volumes, thus eliminating the impact of price changes. Productivity ratios are usually set up as follows: Output (physical goods or services quantified) Input (direct labor hours or machine hours)
Capital Structure and Insolvency Ratio

The capital structure of an enterprise consists of debt an equity funds. The sources and composition of the two of capital determine to a considerable extent the financial stability and long term solvency of the firm. Equity capital is risk capital, and the return on investment to invertors is subject to many uncertainties. Debt is paid is paid on a specified date, usually with interest. There is no ideal capital structure common to all firms. In general, a firm should not have a heavy amount of long-term debt and preferred stock in relation to common stock and retained earnings. Companies with only common stock capitalization can be attractive to both investors and creditors because there are no prior claims ahead of the common.
CAPITAL STRUCTURE RATIO Equity to Total Liabilities

The relationship of equity to total liabilities is an important measure of capital structure of a business. The enterprise is less vulnerable to declines in business or the economy, the cost of carrying debt is reduced, and the company should be able to meet its obligations more easily. Formula Equity to total liabilities = Shareholders equity Total liabilities
Debt to Equity Ratio

This ratio measures the amount of leverage used by a company. It measures the number of times the shareholders capital has been leveraged by the use of debt. A highly leveraged company involves a substantial use of debt and a limited use of equity. This ratio is an indicator of creditors risk. Formula Debt to equity ratio =
Total liabilities Shareholders equity
Shareholders Equity to Total Assets

The shareholders equity to total assets ratio measures the proportion of the firms assets that are provided or claimed by the shareholders. If the shareholders equity is a small proportion of total assets, the firm may be viewed as being financially weak, because the shareholders would be viewed as having a relatively small investment in the firm. On the other hand, a high ratio of shareholders equity to assets can represent a relatively large degree of security for the firm, but it also indicates that the firm is not highly leveraged. Formula Equity to Total Assets Shareholders equity Total assets
Number of Times Interest Earned

The number of times interest is earned ratio is a measure of the debt position of a firm in relation to its earnings. The ratio indicates the companys ability to meet interest payments and the degree of safety available to creditors.
Formula
Times interest earned = Income before taxes & interest charges Interest Charges
Book Value per Common Share

Book Value Shareholders Equity Applicable to per Common Shares = Common Number of Common Shares Share Outstanding
This ratio measures liquidation at reported amounts.

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Book Value per Share or Break up Value per Share

Book value per share is a figure that represents what the shareholders would receive for their shares of ownership if the corporation were liquidated without gain or loss (i.e. based on going concern concept basis).
Formula
Common stockholders equity ---------------------------------------------Number of common shares outstanding
Concept Review Test

Fill in the correct answer from choices given:
1. Cash flow statement classifies cash flow during the period from operating, __________ and financing activities.
a) non-operating b) investing c) working capital
2. Auditors Report of a listed company is addressed to _______ .

a) Directors b) Chief Executive c) Members
Concept Review Test

3. The relationship of current assets and current liabilities is an indicator of a firms ______________ positions.
a) Financial b) liquid c) profitability
4. EPS is widely used in judging the ________ performance

a) Operating b) Leverage c) ROI
Concept Review Test

5. Dividend yield = Dividend per share / _______________

a) Face value per share b) Market value per share c) Net Income per share
Case studies
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Discussion on relevant ratios for various users of financial statements

INTERNAL USERS
Marketing & Sales Manager No of days in Account Receivable and Receivable turnover Product wise profitability ratio Key sales and profit contributing products( 80 / 20 rule ) Inventory Manager No of days in Inventory , Inventory turnover Production Manager Input vs output ratio Yield / wastage ratio vs standard and industry trend Database Labour efficiency ratio
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Discussion on relevant ratios for various users of financial statements

EXTERNAL USERS
Creditors Liquidity Profitability Cash flow analysis Banker Debt Equity , Interest Coverage Liquidity , Profitability Employees Profitability growth Shareholders Dividend yield, Dividend payout , EPS Liquidity , Cash Flow Analysis ,PE
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Case Study I Account Receivable Ratio

The comparison of two years data of a company are as follows.
(matter of concern ,A/C Receivable has increased by 20%)
2001
2002
Sales Rs. 1,200,000 Rs. 1,560,000 Accounts receivable 100,000 120,000 Turnover ratio 12 14.2 Days sales outstanding 30 28 Credit terms 30 days Required: Evaluate this information and advise effectiveness of receivable management
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Case Study II Inventory Ratios

The following information is available for a small manufacturing company:
(matter of concern ,Inventory has increased by 42%)
2001 Sales Rs. 1,200,000 Inventory 200,000 Cost of goods sold 881,000 Inventory turnover 4.4 Days in inventory 83
2002 Rs. 1,560,000 284,000 1,000,000 4.1 89
Required: Comment on the above trend from the point of view of 107 inventory management.
Case Study III Business Focus

Mr Rick Burrock, the managing director of an accounting company based in Minneapolis, advises his small business clients to keep a tight rein on credit extended to customers. You need to convey to your customers, right from the beginning, that you will work very hard to satisfy them and that in return, you expect to be paid on time. Start by investigating all new customers. A credit report helps, but with a business customer you can find out even more by requesting financial statements.. Using the balance sheet, divide current assets by current liabilities to calculate the current ratio. If a companys current ratio is below 1.00 it will be paying out more than it expects to collect; you may want to reconsider doing business with that company or insist on stricter credit terms.
Source: Jill Andresky Fraser, Hands on Collections: Get paid Promptly, Inc., November 1996, p. 87
Required: Comment on above based on your practical experience.
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Case Study IV
Operating Cycle
M/s Tycon Corporation was formed in 1985 with a share Capital Rs.10 million to start the business of chemical manufacturing and sales. The land, building and machinery cost was Rs.15 million. Therefore sponsors financed shortage of Rs.5 million from acquiring long term loans for GBL Financing Corporation at 8% interest per annum. Now in order to operate the business activities working capital funds were required to finance inventory and receivables.
You are required to submit your proposal for working capital requirement to one of bankers based on following information.
The company generally pays its suppliers six weeks after receiving an invoice, while its debtors usually pay within four weeks of invoicing. Raw materials stocks are held for a week before processing which takes three weeks, begins. Finished goods stay in stock for an average of two weeks. The size of weekly investment in inventory or receivable is Rs.500,000.
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CASE STUDY-V Effect on Profit for Extending Credit

The main cost of offering credit is the interest expense and of course risk of bad debts . How can we assess the effect on profit? Beeta Company sells Toys for Rs 1,000 which enables it to earn a profit, of Rs 100. The customer does not pay until a year. Beeta relies on overdraft finance, which costs 10 % pa. The effect is: Net Profit on sale of Toys Interest cost overdraft Rs 1,000 x 10% pa Real profit after 12 months credit Rs 100 (100) Nil
The entire profit margin has been wiped out in 12 months because of delayed payment.
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CASE STUDY-V Effect on Profit for Extending Credit

If customer paid after six months, the effect would be:
Net Profit Interest cost overdraft cost (Rs 1000 x 10% pa x 6/12 months) Rs 100
( 50) 50
Half the profit has been wiped out. ---------------------------------------------------------------------------------------------------------
If the cost of borrowing is 18%, then the profit would be absorbed before seven months had elapsed. If the net profit is 5% and borrowing costs were 15%, the interest expense would exceed the net profit after four months.
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Case Study VI Based on following data complete the Balance Sheet

RATIOS: Current ratio 1.6 , Long term debt to equity is 40%, shareholders equity is Rs 50,000, Total assets turnover is 3 times. Inventory turnover to cost of sales is 8 times,credit sales to total sales 80% , average collection period is 18days (360days a year).Gross profit at 20% is Rs 20,000/= HEADS OF B/S CASH+DEBTORS+INVENTORY+FIXED ASSETS= CREDITORS+LONG TERM LOAN+EQUITY
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WORKING CAPITALCase Study VII
A companys annual sales is Rs 8 million with a gross profit on cost of 60%. It normally pays creditors two months after purchases are made, holding months worth of stock. It allows debtors 1.5 months credit and its cash balance currently stands at 1,250,000 rupees. What are its current and quick ratios?
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WORKING CAPITALSOLUTION - Case Study VII

Rs in million SALES COST OF SALES GROSS PROFIT 160% 100% ------60% 8 5 ----3
CREDITORS DEBITORS STOCK CURRENT RATIO QUICK RATIO
= 2/12 x RS 5m = 1.5/12 x RS 8m = 1/12 x RS 5m = 0.417+1+1.25 0.833 = 1+1.25 0.833
= Rs 0.833m = Rs 1m = Rs 0.417m
= 3.2 = 2.7
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WORKING CAPITAL-Case Study VIII McDonalds Corporation provides an interesting illustration of the use of financial ratios. Data for a recent year appear below : Rs. Net income Interest expense Average total assets Stockholders equity Dividends per share Earnings per share Market price per share Book value per share 1,427 million 340 million 14,503 million 6,857 million 0.26 1.97 42.125 10.73
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WORKING CAPITAL-Case Study Solution

Some key financial ratios are computed below : Return on 1,427 total assets 14,503 Return on common stockholders equity Dividend payout ratio 1,427 6,857 0.26 1.97
= 9.8%
= 20.8%
= 13.2%
Dividend yield ratio
0.26 42.125
= 0.62%
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WORKING CAPITAL Case Study -comments

The return on common stockholders equity of 21% is higher than the return on total assets of 9.8%, and therefore the company has positive financial leverage. About half of the companys financing is provided by creditors; the rest is provided by stockholders. According to the companys annual report, Given McDonalds high return on equity and assets, management believes it is prudent to reinvest a significant portion of earnings back into the business. Accordingly, the dividend yield is relatively modest. Indeed, only 13.2% of earnings are paid out in dividends. In relation to the stock price, this is a dividend yield of less than 1%. Finally, note that the market value per share is over four times as large as the book value per share. This premium over book value reflects the markets perception that McDonalds earnings will continue to grow in the future.
117
WORKING CAPITALCase Study IX

Analyze the following information from the viewpoint of its implications for working capital policy: Present position Budget for next year Sales 250,000 288,000 Cost of sales 210,000 248,000 Purchases 140,000 170,000 Debtors 31,250 36,000 Creditors 21,000 30,000 Raw materials 35,000 60,000 Finished goods 40,000 43,000 Work-in-process 17,500 30,000 Assume all sales and purchases are on credit.
118
WORKING CAPITAL Case Study -Solution

Analysis of the figures and cash operating cycle it is revealed that working capital investment is being increased. Debtor balances are moving pro-rata with sales, the current and budgeted collection period both being 46 days. However, some additional finance will be taken from creditors as a result of the payment period being increased from 55 days to 64 days. This increase represents about 16% and is not particularly significant unless creditors demand payment within 60 days, or offer discounts for payment within that 119 time (which will be lost).
WORKING CAPITAL Case StudyA significant change in the turnover of stock levels is anticipated. Raw materials stocks turnover will be decreased by 29% and work-in-progress by 31%, while finished goods stock turnover will increase by 10%. The implication is that production will increase while sales will fall; in the period following the budget, stocks will be very high. The overall impression is that unnecessarily high investment in raw materials and work-in-progress is being undertaken. A reappraisal of the situation should be made to see if these stocks can be reduced, thereby releasing funds for other uses. It may also be possible to reduce debtors to their current levels.
120

WORKINGS CURRENT BUDGET
1.
2.
3.
Creditors Average payment period (365 x Creditors) 365 x 21 = (55 days) Purchases 140 Debtors Average collection period (365 x Debtors) 365 x 31.25 = 46 days Sales 250 Finished stock turnover = Cost of goods sold 210 Finished goods stock 40 = 5.25 times pa or 70 days
365 x 30 = (64 days) 170
365 x 36 = 46 days) 288

248 43 = 5.8 times pa or 63 days
121

WORKINGS 4. CURRENT Raw materials stock turnover = Purchases 140 Raw materials stock 35
= 4 times pa or 91 days
BUDGET 170 60
= 2.83 times pa or 129 days
5.
Work-in-progress turnover = Cost of goods sold 210 248 Work-in-progress stock 17.5 30 = 12 times pa or 30 days = 8.26 times pa or 44 days Length of cash operating cycle
182 days
218 days
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Case Study-X CHANGES IN CREDIT TERMS

JF Ltd achieves current annual sales of Rs 1,800,000. The annual profit and loss account is as follows. Sales Rs 1,800,000 Cost of sales 1,440,000 360,000 Bad debts expenses 18,000 Profit 342,000 The management consider that if credit terms were eased from 30 days to 60 days credit, the sales will increase by 25% but bad debts will also increase from 1% to 3%. The company cost is 20% on its investments. The costs of sales are 75% variable and 25% fixed. Assume there would be no increase in fixed costs from the extra turnover; and that there would be no increase in average stocks or creditors. Should the company opt for easing the credit terms?
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Case Study XSOLUTION
The increase in profit before the cost of additional finance for Option. A can be found as follows. a) Increase in contribution from additional sales 25% x Rs 1,800,000 x 40% * Rs 180,000 Less increase in bad debts (3% x Rs 2,250,000) Rs 18,000 49,500 Increase in annual profit 130,500 * The C/M ratio is 100% - (75% x 80%) = 40% b) Proposed investment in debtors Rs 2,250m=,000 x 1/6 Rs 375,000 Less current investment in debtors Rs 1,800,000 x 1/12 150,000 Additional investment required 225,000 Cost of additional finance at 20% Rs 45,000
c)
CONCLUSION
As the increase in profit is Rs 130,500 which exceeds the cost of additional financing cost of Rs45,000, therefore credit terms be relexed.
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Case Study Select a companys annual report

Review the Financial Statements and comment on following:
1. 2. Workout Horizontal, Vertical, Common Size Statement & all Ratios Comment separately on:
a. b. c. d. e. Liquidity Profitability Turn over of Inventory & Receivable Market ratio Capital Structure
With help of above results, advise for buying this companys Share at Rs. per share Discuss other factors which may effects the decision of buying above shares The net profit is Rs. million whereas cash flow statement shows net surplus of Rs. million. Justify the difference.
125
Case Study XV Review of Financial Statement

6- Find out purchases of raw material, direct labor and factory overheads figure in Notes to the Accounts. 7- Read the Nature of Business and Companys history, Accounting Policies, Director Report Auditors Report shareholding break-up, Contingent Liability & Commitments, value added statement and briefly comment on each of above separately 8- Is the company meeting its current obligations? 9- How the inventory is financed ? And comment on efficiency of inventory management. 10- What is other significant matter in financial statement beside discussed above which is useful for shareholders and bankers. 11- Why the dividend is much less than profits? ( dividend payout )
126
Case Study XVI

Comments for News paper on Financial Statements
Based on all above data and analysis results, you are required to write a Business Review that way be published in a newspapers about this company.
127
Case Study XVII REVIEW OF ACTUAL PUBLISHED ACCOUNTS
Based on the financial statement just reviewed, you are required to: 1- Prepare projected profit & loss account for next year considering following assumptions:
2Sales to grow by 20 %annually. Cost of goods sold consists of 30% Material, 20% Labor and 50% factory overhead of which 40% are fixed overhead . No inflation is expected in Material prices, labor cost and variable overhead. Fixed overhead and admn., selling, financial charges etc to increase by 10% only.
Advise expected profits and dividend for the next year.

128
ANALYSIS OF FINANCIAL STATEME
Concept Review Test
PART (A)
Tick the correct answer in relevant column.

TRUE FALSE ______ ______ ______ ______ ______
1. 2.
The financial statements are normally prepared on current cost concept. Revenue & costs are recognized as they are received or paid respectively and not when earned or incurred.
______ ______
3. 4. 5.
Shareholders equity includes share capital and liabilities. ______ Balance Sheet shows operating results of the company. _____ Sales is recorded at the time of receipt of order from the customer ______
6-
Financial Statements are prepared on cash
basis.
______
______
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Concept Review Test
PART (A)
7.
Tick the correct answer in relevant column.

TRUE FALSE
Dividend is distribution of profits to shareholders and bankers Ordinary Shares issued at a discount-It has no effect on current ratio Low Inventory Turnover indicates that carrying cost of inventory is also low Formula to calculate EPS is = Net Income Value of Ordinary Shares Going Concern concept effect Valuation of Assets Inventories are valued at lower of cost and net realizable value
-----------
-----------
8.
-----------
-----------
9.
-----------
-----------
10.
---------------------
---------------------
11. 12.
-----------
-----------
130
Concept Review Test
PART (B)
1.
Fill in the blank:
2. 3.
Dividend income is recorded in books of account when it is approved by ______________ (a) Shareholders at AGM (b) Board of Directors (c) Managing Director Capital Reserve can not be used for issuing _______________ (a) Cash Dividend (b) Bonus Shares Bonus Share is also called ______________ (a) Right Shares (b) Stock Dividend (c) Preference Shares Associated company means any two or more companies interconnected with each other and director of a company hold or control share with atleast ________ voting power in another company. (a) 50% (b) 25% (c) 20%
4.
5.
____________ opinion by External Auditors is expressed when the auditor concludes that the financial statements give a true and fair view in accordance with identified financial reporting framework (a) A Qualified (b) An unqualified (c) An adverse
131
Concept Review Test
6.A ____________ is a postponement of the recognition of a revenue expenditure already incurred or paid because it is likely that the benefits may be available for more than one year. (a) Capital Expenditure(b) Revenue Expenditure (c) Deferred Revenue Expenditure 7. The liability of Partners in Partnership firm is _____________ (a) Limited (b) Unlimited (c) nil 8. Financial Statement analysis involves tools and techniques which enable analyst to examine past and __________. (a) Future position ( b) Current position (c) Previous Trend 9. Current ratio express _________ position of the company (a)Financial ( b) Liquidity (c) Profitability 10. Higher inventory turn over express _________ investment in inventory a) Low (b) High (c) Reasonable
132
Concept Review Test
11.
Low A/c receivable turn over ratio shows ____________ Receivable Management. a) Efficient b) inefficient c) inappropriate 12 Working Capital Ratio express the relationship between current assets and _________ . a) Fixed Assets b) Long Term Liab c) Current Liab 13.Dividend yield = Divided per share -- ________________ a) EPS b) Break up value c)
M/V of shares
14.Price Earning Ratio express what market is willing to pay for every ________ rupees. a) Rs.5 b) Rs.3 c) Rs.1 15. Book value per share = Shareholder Equity -- _______________. a) Reverses b) No. of shares c) Value of shares 16.) Ratio can be computed from any _________________. a) Single number b) Pair of numbers
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ACCOUNTING AS A TOOL FOR BUSINESS DECISION MAKING

A. R. Suriya & Co.

1 What data is required? 2 Whether the decision maker is:

A. R. Suriya & Co.

External Users Shareholders Customers Bankers Tax authorities

DECISION MAKING FOR EXTERNAL USERS

A. R. Suriya & Co.

DECISION MAKING FOR EXTERNAL USERS (2)

A. R. Suriya & Co.

A. R. Suriya & Co.

DECISION MAKING FOR EXTERNAL USERS (3)

DECISION MAKING FOR EXTERNAL USERS (4)

Before reaching to conclusion based on analysis we need to consider

A. R. Suriya & Co.

ANALYSIS OF FINANCIAL STATEMENTS

A. R. Suriya & Co.

Broad Categories of Financial Ratios

Analysis of Cash flow Statements

Within Annual Report Auditors Report Directors Report

A. R. Suriya & Co.

RELEVANT RATIOS FOR VARIOUS EXTERNAL USERS OF FINANCIAL STATEMENTS

A. R. Suriya & Co.

DECISION MAKING FOR INTERNAL USERS

DECISION MAKING FOR INTERNAL USERS (2)

A. R. Suriya & Co.

DECISION MAKING FOR INTERNAL USERS (2)

A. R. Suriya & Co.

ANALYSIS OF FINANCIAL STAEMENTS

to examine in detail in order to discover meanings

ANALYSIS OF FINANCIAL STAEMENTS

ANALYSIS OF FINANCIAL STAEMENTS

ANALYSIS OF FINANCIAL STATEMENTS

ANALYSIS OF FINANCIAL STATEMENTS

ANALYSIS OF FINANCIAL STATEMENTS

Efficiency of receivable and inventory management

MATERIAL NEEDED FOR ANALYSIS

Benchmark for Comparison

Example of Vertical Analysis of P/L

Example Horizontal Analysis of Balance Sheet

12,000 60,000 80,000 3,000 $ 155,000 40,000 120,000 $ 160,000 $ 315,000

23,500 40,000 100,000 1,200 $ 164,700 40,000 85,000 $ 125,000 $ 289,700

Analysis Period Amount

Base Period Amount

(48.9) 50.0 (20.0) 150.0 (5.9) 0.0 41.2 28.0 8.7

Common size statement

Using key relations among financial statement items

Ratio Analysis ..II

Ratio Analysis ..III

The need to look beyond ratios

The need to look beyond ratios

The need to look beyond ratios

The need to look beyond ratios

Limitation of Ratio Analysis

This ratio measures the short-term debt-paying ability of the company.

Acid-Test = Rs50,000 = 1.19 : 1 Rs42,000 Ratio

Liquidity Ratios .. III

Assets Management Ratios Activity / Turnover / Efficiency/Performance Ratios

Days Sales in Inventory

Assets Management Ratios Activity / Turnover / Efficiency/Performance Ratios

Assets Management Ratios Activity / Turnover / Efficiency/Performance Ratios

Assets Management Ratios Activity / Turnover / Efficiency/Performance Ratios

Assets Management Ratios Activity / Turnover / Efficiency/Performance Ratios